High correlation between oil and risk assets

Not only have markets been volatile this year, but investor fear has “driven [the] correlation between oil and risk assets, such as stocks and high-yield debt, toward 1,” says CIBC Asset Management portfolio manager Craig Jerusalim.

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Typically, as correlation between two securities approaches 1, those securities more closely rise and fall together. That means those two securities provide less diversification within a given portfolio.

Read: The search for uncorrelated assets

Right now, many areas of the Canadian market have been struggling simultaneously, adds Jerusalim, who co-manages the Renaissance Diversified Income Fund. Some concerns for the economy and market are “job losses, high bank loan-loss provisions [and] capital expenditure cuts.”

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Historically, he explains, the correlation between oil and risk assets hasn’t been as high as it is currently. This is mainly because low oil prices have tended to boost markets by encouraging consumer spending. But now, on days when the price of oil drops, so too do stock prices.

In past market environments, adds Jerusalim, the only times the correlation between low oil prices and the rest of the stock market has tightened has been during recessions.

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However, he doesn’t predict a North American recession. In the U.S., “Only one of the four main National Bureau of Economic Research recession indicators is entering cautionary territory, [and that’s] industrial production. But, strong indicators of personal income and employment trends are offsetting weakness in industrial production.” And another key indicator, retail sales, have improved.

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So, while investors should be cautious, they can look for opportunities. “The fact that stocks are highly correlated suggests [even] the highest-quality stocks are being painted with the same brush” as low-quality holdings. He recommends investors drop risky and highly leveraged stocks in favour of higher-quality companies that were too expensive before this market correction.

Read: 4 things to know about the market correction

ARC Resources and Canadian Natural Resources are two examples of companies that have strong balance sheets and competitive advantages. Jerusalim says they’re “well-positioned to thrive once the market recovers.”

Both companies are in the exploration and production sector, he notes, and their stock prices have corrected between 30% and 40% from previous highs. “Even if we haven’t seen the absolute [lowest] price for oil, these companies are in a much stronger strategic position relative to their peers. And, they have cost structures that can sustain almost any downside scenario.”

Read: 5 things to watch in Canada’s energy sector

In other sectors, “High-quality companies such as Dollarama, Restaurant Brands International and Gildan Activewear have [also] corrected more in the past few months than in any time over the past five years. These companies aren’t dirt cheap by comparative standards,” but they’re great companies that have strong growth forecasts.

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